Contracts For Difference: Should You Trade CFDs?

Why do traders and stockbrokers and their clients trade contracts for difference or CFDs?

After all, there are stocks and shares, forex and a large variety of other trading instruments around in the market.

What is Contract for Difference?

Contract for difference is a contract to trade the price of a stock without the formal ownership of a stock or share in traditional share trading.

You can go long or short on CFDs, and can be traded on margin, and interest charges apply on long positions, and paid on short. There are different types of CFD in today's market, including market maker, DMA or Direct Market Access or Exchange CFDs in certain countries.

You can read more about these 3 different types of Contracts for Differences or CFDs here.

Recently in the past 10 years, contracts for difference or CFDs have become popular. But you must know the advantages and disadvantages of CFDs, especially after the global financial crisis or GFC over 2007-2010.

Now in 2011, CFDs are making more of a comeback as financial crisis is on the brink of easing off.

With choosing a CFD broker or provider itself, there are various considerations to take into account when trading CFDs.

This includes the brokerage they charge, the interest, the spread, the CFD market they offer (ie what stocks, indices, commodities and other derivatives thaty offer), the types of accounts, CFD platforms and charting abilities of these trading platforms, the helpfulness of the dealing desk, stability of the company and much more. This is further discussed in this section on how to how to choose a CFD broker or provider.

But to the question of trading CFDs, here's what you should know about trading CFDs and their benefits and pitfalls:

Advantages of CFDs or Contract For Differences:

1. The first advantage of CFDs is the leverage.

Beware, this is also the pitfall that inexperienced traders can fall into (we'll come to this later).

The leverage enables a trader to have a leveraged float larger than their cash float. So this will magnify their trading returns. This is more leverage than straight shares with no leverage.

So if your CFD trading system is profitable, your profits are magnified.

2. The second advantage is short trading.

Short trading with CFDs cost the same as going long and the interest component is paid to the trader instead of the trader paying it to the provider, and there is no need for a full service provider and all its expenses.

They are a low cost entry to short selling.

However, in 2008 there has been temporary bans on short selling of shares in several countries around the world including the US, the UK and Australia. Though CFDs are a "derivative product", many providers reduced or stopped for a while the ability to short CFDs as the ban interfered with CFD broker's ability to hedge positions.

3. Relatively low commissions.

Compared to many share brokers, and full service brokers, the commissions in and out of a trade for contracts for difference is low compared to that of shares.

Commissions and costs of trading reduce the profitability of trading as it can be a fixed cost, as there is a minimum commission in most cases.

But lower costs help traders improve their profitability.

Disadvantages of Contract For Difference:

1. The leverage - when misused.

This is a mistake that many traders get into.

During great bull run yeas, many traders max out their leverage and took full advantage of their 10 to 1 leverage.

And when the value of their CFDs went up, their available margin increased and they took even more positions. This is all well and good if the stocks keep going up, but wiser traders will be more cautious with their leverage.

Even though say 10:1 leverage is availble, they may trade with much less leverage utilisation.

Why? It means less risk of margin calls. Also, if there is a losing period in the trading, that this won't be as large. Remember that leverage magnifies your trading results both ways. So here is where money management comes in to choose the trade sizes and number of positions that will result in a satisfactory profit and potential drawdown amount, depending on your situation.

2. Possible slippage

Slippage is a potential problem in non or low liquid stock CFDs.

If volume of trading is low, then your intended exit price may not occur. So stop losses though present, may result in a lower than expected sell price due to liquidity issues.

The way to prevent slippage is to trade in liquid markets.

Also observe the performance of your market maker to ensure that there exists and trades are performed promptly and with miminal slippage.

3. Hold ups when takeovers occur

When there are stock takeovers or company collapses, your funds may be held up for months until the company is liquidated or taken over.

Such events happen in the real market place and can affect CFDs.

So if you're short a CFD that devalued to zero, you may not be paid the profits of doing do for months. What exactly happens in such situations does depend on each CFD provider as well. Obviously if you're long a stock CFD that went to zero, then this is a losing trade. Hence it comes back to responsible use of margin and leverage.

To find out more about what is a CFD and how they work, see this Contracts For Difference or CFD Tutorial.

So as you can see, there are benefits and pitfalls of trading contracts for difference.

Take advantage of benefits but minimise the pitfalls.

So ensure that you know about CFD trading and how it all works before trading them.